Institutional money continues to pour into alternative investments, despite lower return expectations and some fears that too much money is chasing too few deals.
The availability of capital is causing general partners to pay up for deals, which lowers returns, said James Meynard, director of trust investments with the $18.7 billion pension fund for BellSouth Corp., Atlanta.
"A lot of money is in the coffer. Most of us are aware of that," he said.
"With all these groups (partnerships) with so much money, if you try and give a seller a haircut, he doesn't have to go far to look for a (better) deal," said Mr. Meynard. Some sectors of the alternative investment category are susceptible to an auction atmosphere, with the deal going to the highest bidder, said Mr. Meynard.
The big buy-out and corporate finance firms have been the most successful at raising money, according to Mr. Meynard, most notably, Kohlberg Kravis Roberts & Co.; Clayton, Dubilier & Rice; Leon Black; Thomas H. Lee Co.; Forstmann Little & Co.; and E.M. Warburg Pincus & Co.
"There is also a sense that a lot of money has been raised in intermediate and small funds," he said. "It's everyone's concern."
But that concern hasn't resulted in a pull back from alternative investments.
"You don't avoid it," said Mr. Meynard."You do your best to pick good funds and be willing to accept lower returns.
"You either fill the allocation or you change it."
Why alternatives are attractive
Among the reasons alternative investing is attractive to investors like Mr. Meynard and many of his peers:
Return expectations remain higher than other options;
There is alignment of interests between the managers and investors in the partnerships; and
Timing such investments is thought to be impossible, so investments are made over time in different return environments.
Indeed, 1995 was a record year for fund raising by alternative investment funds. And there are indications some sectors will surpass their 1995 levels this year.
According to The Private Equity Analyst, a Wellesley, Mass., newsletter, domestic private equity partnerships raised $27.2 billion in 1995, a 29% increase from the year before and the fourth consecutive increase in partnership commitments. The bulk of the money was committed to funds that will invest in buy-outs and other corporate finance partnerships.
Meanwhile, pension funds accounted for 49.7% of the money committed to alternative investment partnerships in 1995, reported The Private Equity Analyst and Venture Economics, a Boston-based newsletter. Banks and insurance companies were second, accounting for 17.5%.
That's the biggest commitment pension funds have made to alternatives in five years, and the third largest in 15 years.
(According to the data, pension funds steadily increased their share of the alternative investments pie during the past 15 years, going from a low of 23.1% in 1981 to 50.1% in 1986 and peaking at 52.5% in 1990. Their share of alternative investment commitments fell to 42.2% in 1991, but has risen steadily since that time.)
Buy-outs, venture cap promising
This year, the biggest news might be buy-out funds, which have raised $6.6 billion in the first six months of 1996, said Kelly McGough, a manager with Venture Economics.
And venture capital seems poised for a comeback; commitments far this year are ahead of those for the first half of both 1994 and 1995.
According to Venture Economics, $2 billion has been committed to venture capital partnerships, year to date, compared with $1.6 billion at midyear 1995 and $1.9 billion for the same period in 1994.
Despite the money pouring in, industry participants don't think alternative investing will suffer the same fate as real estate investing earlier this decade.
The main reason: the firms promoting most alternative investment deals are investing alongside their clients. That creates an alignment of interests that was lacking with real estate managers, none of whose money went into the property purchases.
In most alternative investment deals - especially buy-out and other corporate finance funds - "the general partners put up substantial money alongside the limited partners," noted Kevin Albert, managing director of the private equity group at Merrill Lynch & Co. Inc., New York. "It would be dysfunctional for them to do deals if they weren't confident they would work."
Also, general partners are sharing fees with the investors. And fees and expenses are subtracted from gains before calculating incentive fees, Mr. Albert said.
Money not necessarily invested
These features ensure money committed isn't necessarily invested, unless high returns are achievable, he said.
"You are committing today, but they don't spend the money for a while," said Jay Fewel, senior investment officer-equity with the roughly $25 billion Oregon Public Employes' Retirement System, Salem.
"You hope that if they (general partners) feel prices are excessive, they will back off for a period," said Mr. Fewel. "Some deals come the way of auctions, and some funds have proprietary deal flow."
The Oregon retirement system probably won't commit additional money to buy-out funds because so much money has been raised, said Mr. Fewel.
The fund has an allocation to alternative investments of between 5% and 15%, with 11% committed. Oregon has committed money to two partnerships this year, KKR and Providence Equity Partners, both buy-out funds.
Oregon is the largest investor in KKR, committing a minimum of $400 million up to $800 million to KKR's newest fund, but no more than 20% of the fund.
Providence Equity received $75 million from Oregon, said Mr. Fewel. It will focus on media companies.
"Without question, a lot of money has gone in, primarily to buy-outs," said Mr. Fewel. "I'd like to think our groups are of a (high) quality."
High-quality partnerships key
Selecting partnerships that are perceived to be of high quality was a recurring theme among pension fund executives.
"We've taken the flight to quality approach," said Erica Bushner, director of venture capital and alternative investments for the $16.6 billion Commonwealth of Pennsylvania State Employes' Retirement System, Harrisburg.
The system has reinvested with its managers, who themselves invest during different market cycles, said Ms. Bushner.
"We are very selective," she said. "We only look at blue-chip funds that will do well in any cycle.
"We don't have to seek new relationships," said Ms. Bushner.
The partnerships in which Pennsylvania is invested are Golder, Thoma, Cressey, Rauner Inc.; TA Associates; and Madison Dearborn Partners Inc.
"They have been around a long time," said Ms. Bushner. "Those are all very exceptional managers."
Pennsylvania State Employes' has a 7% commitment to alternative investments; less than 3% has been invested, said Ms. Bushner.
The system's biggest challenge during the surge in alternative investing has been getting money committed to desirable partnerships before they close, said Ms. Bushner.
In one instance, the fund committed money to a partnership before the general partners began marketing the investment.
"We are one of the first to try and commit," said Ms. Bushner. "You have to be pro-active in getting the commitment out. If you wait, you won't have a chance to get in."
Some investors are seeking alternative investment sectors that have drawn less interest until recently, including international private equity, mezzanine finance and restructurings.
Oregon, for example, is an investor in Hancock Venture Partners Inc.'s fund of funds that will invest in international private equity, said Mr. Fewel.
Also, "the public markets are overheated, and when you have a correction, you might have (some) bankruptcies," he said. The bankrupt companies might be good companies with poor financial structures, and that might create opportunities, said Mr. Fewel.
"We have an opportunistic view to the marketplace," he said.